There seems to be an obvious solution to rising inequality: higher taxes. But there's an inconvenient fact here. The way most advanced, industrial countries have made real gains on inequality is through relatively regressive taxes that fund programs that reduce inequality. In fact, America's tax system is already unusually progressive by international standards. Our ongoing research suggests that this unusual relationship is not a coincidence.
The countries in northern Europe that have made the biggest strides in reducing economic inequality do not fund their governments through soak-the-rich, steeply progressive taxes. Instead, they have broad-based taxes that ask all workers to contribute to a generous welfare state. Countries with highly progressive taxes that disproportionately hit the rich — like the United States — tend to have the stingiest welfare states.
The figure below makes this point clearly, showing that the more progressive a country's taxes, the less the country does to reduce inequality.
In this chart, redistributive effort refers to percent reduction in the market Gini coefficient — a useful measure of inequality. Household tax progressivity measures how much more (or less) of the tax burden falls on the wealthiest households, compared to households at the middle and the bottom. Both measures are from the OECD.
There's a reason governments in nations with highly progressive taxes end up spending less to combat inequality — those taxes raise relatively little revenue for both economic and political reasons. For instance, the highly progressive taxes in the United States have fostered intense backlash from powerful economic elites, pushing high-earning individuals and firms to find loopholes and lobby for top-end cuts.
The reason Northern European countries with more regressive taxes achieve such high levels of labor market equality, despite less progressive tax systems, is that they spend money on increasing the skills and earning power of low-end wage earners. Countries with the lowest levels of inequality have learned that policies to cultivate skills for all workers and to achieve full employment policies can accelerate economic growth while also reducing inequality. Large investments in human capital reduce societal conflicts over the distribution of resources, even while expanding the economic pie.
Countries like Denmark and Sweden also redistribute income, but this largely occurs through the funding of egalitarian social benefits — public health care, education — that also contribute to a productive, healthy workforce. Whereas these countries raise most of their revenue in a relatively more regressive manner, they use this revenue to fund social benefits that improve both the living standards and productive capacities of lower-class residents. In contrast, countries with the most progressive tax systems, like the United States, tend to raise most of their revenue through levies on the wealthy and on capital, and end up investing little in job training and other social benefits that reduce inequality.
The lesson for the United States is that relying on the wealthiest citizens and corporations to fund the public sector will not create the revenue necessary for large-scale initiatives to reduce inequality. Emphasizing redistribution as the central principle for tax policy is needlessly divisive, leads to smaller government revenues overall, and thus misses the positive benefits that having more revenues can offer if invested wisely in promoting success for all. In this, the Democrats, who've pledged to not raise taxes on people making less than $250,000 a year, are little better than the Republicans, with their no-new-taxes-ever pledge.
The way a tax system fights inequality isn't just redistribution. It's by generating enough revenue to fund programs and benefits that help middle class, working class, and poor people participate and succeed in the economy. While talk of taxing top earners may make for good political rhetoric on the left, relying on such taxes cannot pay the bills.